US Federal Reserve Rate Cut and its implications *

US Fed funds rate at near zero:

The US Federal Reserve had on December 16, 2008 cut its benchmark interest rate, US
Fed Funds rate, to a historic low of 0% to 0.25% for the first time since 1954. The cut
was made from 1% to a low of 0% to 0.25%, signifying a cut of at least 75 basis points.
Previously, the US Fed used to set a specific target for the Fed funds rate. However, this
time it has set the target rate in a narrow range of 0% to 0.25% which is quite
unprecedented. The federal funds rate is an overnight lending rate among
banks/financial institutions in the US. The rate is also used as a benchmark rate by
banks to fix interest rates for other loans, like, mortgage loans, business loans,
consumer loans and loans to credit card holders. The US Fed uses the federal funds
rate as a tool to balance its objectives of economic growth and price stability. Whenever
inflationary expectations are high in the economy, the US Fed tries to control inflation by
increasing the fed funds rate. On the other hand, if there is a slowdown in the economy,
it will try to inflate the economy by lowering its benchmark rate. With the US inflation
down to 1.7%, the Fed has shifted its focus to growth in the last 15 months.

What the Fed wants to achieve:

The US economy is in trouble. Officially, it has been in recession for more than a year.
The job market is very bleak with the unemployment rate going up to 6.7% at the end of
November 2008. During this current year alone, the total number of unemployed persons
in the US has gone up by 2.7 million with the total unemployed persons at 10.3 million as
at the end of November 2008. Consumer spending has been on a downward spiral.
Business investment and confidence are extremely low. Banks have been unwilling to
lend to businesses or consumer spending for fear of loan defaults. The US companies
are reporting heavy losses, with the latest being a quarterly loss of USD 2.1 billion, by
Goldman Sachs-its first loss since it went public in 1999. To tide over this crisis, the US
Treasury and the US Fed have been trying to revive the US economy. The US
Government has announced a bailout package of USD 700 billion a few months back to
save the economy. Since September 2007, the fed funds rate has been cut from a high
of 5.25% to the present range of 0% to 0.25%. By reducing the rates, the Fed wants to
stimulate the US economy. This way, the US Fed hopes to prevent the economy from
falling into a deeper depression from the current recessionary trend. Only time will tell
whether the US authorities will be successful in their efforts.

What are the implications:

The fact that the US Fed has cut its key fed funds rate to near zero is an open admission
by them that their country is in deeper crisis than anticipated earlier.

Anticipating a cut by the US Fed, the major currencies, Euro, Pound and Yen have
rallied against the US dollar. The dollar’s slide against other major currencies may
continue for some more time. Other countries and central banks may also react to the
US rate cuts in the next few weeks.

* Prepared by: Rama Krishna V, Equity Analyst, State Bank of Mysore, STB, MUMBAI
vrk_100 @yahoo.co.in Date: Dec.17,2008

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The US Fed has further said that it would buy long-term government bonds. Currently,
US Treasurys are at record high prices. With the decision of the Fed to purchase long-
term bonds, the bond prices may go up so high that the yields might be unattractive for
investors, especially, banks. By buying more government bonds, the US Fed would
make the Treasury yields less attractive for banks so that the banks will be encouraged
to resort to normal commercial lending operations, thereby unfreezing the credit
markets.

The big bailout packages, US Fed rate cuts and other extraordinary measures mean that
the US has been printing more and more dollars for economic revival. More dollars in the
system means more budget deficits. The implication is that long-term bond holders are
taking on considerable risk with their investments in US Government securities at this
point of time. The falling interest rates and the rising US deficits are potential negatives
for the dollar.

Market reaction:

Stock Markets: After the rate cut, the US stock markets have reacted positively to the
news. The benchmark-Dow Jones Industrial Average-index on 16.12.08 had closed at a
level of 8,924, up 360 points or 4.2% from previous day’s close. Whereas, Nasdaq has
closed at 1,590, up 82 points or 5.4% and S&P 500 closed at 913, up 45 points or 5.1%.

Bond Market: The US bond market also has rallied after rate cut. The US Government
bond prices have gone up pushing the yields further down. Yields of some important
Treasurys are given below:

US Treasury Yield % Remark

as on 16.12.08
Benchmark 10-year 2.36
30-year note 2.86 For the first time in its history it
dipped below 3% on 15.12.08
2-year note 0.65
3-month note 0.03 For the past few days, it is
hovering around 0%

Crude oil market: Crude oil market has not reacted much to the Fed’s decision signifying
that the demand for oil may not see any revival as long as the world economy continues
to be in recession. The Nymex crude oil price is hovering around USD 44 a barrel.
Obviously, the current hypothesis that a weak dollar will push up commodities’ prices is
not proved correct this time. Moreover, OPEC is meeting in Algeria today, i.e.,
December 17, 2008 and it is expected that the organization may agree on an oil output
cut of two million barrels a day. Oil market may be looking for cues from OPEC rather
than from the US Fed’s rate cuts. The decision by the OPEC is expected in the next few
hours.

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